Fed lifts key rate to brake economy

Worried that worsening worker shortages could spark damaging inflation, Federal Reserve policy-makers yesterday boosted a key interest rate for the third time since June, hoping to slow the economy from a gallop to a trot.

And while the Fed hinted it wouldn't raise rates again this year, some economists say it's possible the central bank will nudge rates higher in February, the first time in the new year the bank's Federal Open Market Committee meets.

The FOMC's final meeting of the year is scheduled for Dec. 21, but many economists doubt the Fed will risk adding to potential upheaval from Year 2000 computer problems.

"I'm of the view that everything points to another hike in interest rates, since you really don't see this economy slowing down much," said J. Patrick Bradley, director of economic and investment research for Baltimore-based Mercantile-Safe Deposit & Trust Co.

While the Fed news was applauded in financial markets, it angered key U.S. business groups worried about the effect of higher borrowing costs on company balance sheets.

"They clearly had room to wait," said Martin Regalia, chief economist at the Chamber of Commerce. "If this were a football game, they would draw a penalty flag for piling on."

Yesterday's quarter-point increase in the federal funds rate to 5.5 percent -- what Fed-member banks charge one another for overnight loans -- followed similar increases in June and August. The Fed's Board of Governors also voted 5-0 to increase the more-symbolic discount rate a quarter point to 5 percent.

The discount rate, the rate at which banks borrow right from the Federal Reserve System, also was increased a quarter point in August. And finally, the FOMC also disclosed it had adopted a neutral stance toward future increases, suggesting -- but not assuring -- that it would stand pat "over the near term."

The "increase in the federal funds rate, together with the [increases] in June and August and the firming of conditions more generally in U.S. financial markets over the course of the year, should markedly diminish the risk of inflation going forward," the Fed said.

By late in the day, commercial banks were already announcing increases in their prime lending rate -- a benchmark upon which many other consumer- and commercial-loan rates are based. Four

top U.S. commercial banks -- Bank of America Corp., Chase Manhattan Corp., First Union Corp. and Wells Fargo Co. -- said their prime rate would rise to 8.5 percent, from the current 8.25 percent, as a result of the Fed announcement.

That will heighten the borrowing costs of both consumers and businesses, one of the outcomes the Fed hopes for when it raises interest rates, since slowing borrowing helps cool the economy.

Stocks shrugged off the news. Major indexes, which had risen strongly ahead of the Fed's 2:15 p.m. announcement, dropped sharply in response, but then reversed course to finish the day with big gains.

The Dow Jones industrial average rose 171.58 points, or 1.59 percent, to close at 10,932.33, while the Nasdaq composite index jumped 73.51 points, or 2.28 percent, to finish at 3293.05 -- its 11th record in the last 13 trading days.

As the head of the central bank, Federal Reserve Chairman Alan Greenspan has played the lead in squeezing inflation out of the U.S. economy -- and receives near-unanimous credit for having done so. Even now, with the economy only two months away from notching its longest run of non-stop growth, inflation has yet to surface as it typically does late in an economic cycle.

That hasn't kept Greenspan from worrying, however.

He worries high stock prices encourages more spending than usual; A rise in stocks increases current nest eggs, increasing consumer confidence and prompting them to use their paycheck for shopping rather than putting money aside in retirement accounts.

Recent figures show that consumers are spending even more than they're taking home, meaning they're dipping into savings or going deeper into debt so that they could spend more on cars, houses, vacations, and other products and services.

The heavy demand for goods and services has forced companies to hire more workers, but the nation's long expansion has created a shortage of qualified workers in many industries. So far, that has not caused a spike in wages as companies outbid each other for employees, but labor costs remain a key focus for the Fed.

Merrill Lynch chief economist Bruce Steinberg said the Fed's next move would likely be triggered by watching the unemployment rate, which fell in October fell to 4.10 percent -- a 30-year-low.

"The Fed's greatest worry is that the United States is simply running out of warm bodies," Steinberg said. "For policy to remain on hold going forward, unemployment can't fall much further."

Eventually, in one form or another, higher costs to businesses hurt the economy. Companies can pass the higher costs along to consumers by raising prices, which is inflationary and means the consumer-dollar doesn't stretch as far. Or companies "eat" the costs, which crimps profits, often results in a big drop in stock prices, and can then force firms into layoffs to get profits back on track.

Greenspan wants to avoid either scenario by gently slowing the economy into a so-called "soft landing." That's what the interest-rate increases are intended to achieve.